The Fed’s real goal in keeping interest rates low is to finance government debt and deficits

When a government spends beyond its means, the options for paying for the spree are unattractive. It can burden the populace with higher taxes, or it can wipe out a portion of creditors’ wealth by inflating the money supply, repaying debts with a debased currency. Or it can do both. The United States is avoiding these choices by borrowing enormous sums, bringing federal debt to almost US$17-trillion, at interest rates that the Federal Reserve has managed to keep very low.

For now.

Fed chairman Ben Bernanke has likened his policy to the monetary regime adopted during the 1940s. For example, in a 2002 speech he gave as a member of the Federal Reserve Board of Governors, Mr. Bernanke noted that until 1951, despite “inflation rates substantially more variable” than today, the central bank fixed the yields on government debt and had “maintained a ceiling of 2.5% on long-term Treasury bonds for nearly a decade.”

In that decade of world war and its aftermath, the Fed enforced the ceilings by purchasing short-term debt, but Mr. Bernanke noted that there was an even more direct method of holding down interest rates.

The Fed could announce explicit ceilings for longer-maturity Treasury debt and “enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.”

His message in the speech was that holding down long-term interest rates can work even better these days than it did 70 years ago. But several special circumstances in those days overcame potential resistance to extraordinarily low interest rates. First, the Fed had political support for its actions. In fact, the interest-rate policy did not originate with the Fed at all but was imposed by the U.S. Treasury, which wanted to finance the war debt as cheaply as possible.

Second, patriotic fervour stoked the public’s appetite for Treasury borrowing during World War II. Hollywood dispatched stars, for example, to cheer people to buy “Victory Bonds.”

Third, the low bond yields and the volatile inflation Mr. Bernanke alluded to existed in the context of rationing and price controls. With the government making all of the important output and pricing decisions, managed interest rates didn’t attract particular attention.

Last but not least was the exceptional position of the U.S. after the war. Where else could U.S. citizens put their money? Europe lay in ruins. America was then the safest place in the world and a destination for much of the world’s talented people. After the war, President Harry Truman and Treasury Secretary John Snyder staunchly defended the low-interest-rate peg. Truman declared that it was his duty to protect patriotic Americans who had bought low-coupon bonds during the war and would suffer heavy losses if interest rates rose. In reality, Federal Reserve documents acknowledge that the reason rates were kept low was to pay down the World War II debt cheaply. But the Fed refused Truman’s insistence that interest rates be kept low to pay for the Korean War too. An accord between the Fed and the Treasury in 1951 released the central bank from having to maintain a ceiling on government debt yields.

And what about today? For now, the Fed is in the fortunate position of being able to mimic its World War II-era strategy. It can allow the Treasury to continue borrowing cheaply while the government expands its deficit spending and debt accumulation. As to places where investors can park their money safely, Europe and the euro have lost considerable credibility since 2008, while Japan has failed to restore any to the yen. China continues under one-party rule, India is still bound in red tape, Russia remains an enigma, Latin America is not yet quite reliable. Australia, Canada and Switzerland can absorb only so much of world-wide savings.

Still, the Treasury cannot count on lasting political support for a Fed policy that allows the government to pay down the national debt cheaply — however much this policy goal can be disguised by talk that the ultra-low interest rates are really aimed at helping the U.S. economy. People trying to save for the future, and those who are already retired can get only minuscule returns from their investments.

Meanwhile, millions of Baby Boomers are preparing to retire and receive money from unfunded entitlement programs, which will put even more pressure on government spending. It is far from clear that the economy will be able to grow as it did after World War II, or that the U.S. will remain a magnet for the flow of talent and capital from around the world. These factors suggest a diminished capacity to pay back the federal debt with stable dollars.

Present Federal Reserve policies haven’t got much to do with any novel monetary or “macro-stability” insights. They achieve what Fed policy achieved during and after World War II — cheap financing of the government’s deficits and debt, and the transfer of wealth from savers to recipients of government largesse. But a day of reckoning cannot be postponed indefinitely.

Mr. Brenner lectures at McGill University’s Desautels Faculty of Management in Montreal and is a member of the university’s pension board and investment committee. Mr. Fridson’s bond-market analysis appears in Standard & Poor’s Leveraged Commentary and Data.

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